inflation: where we are now

In the early days of the financial crisis, after the Fed had opened the monetary flood gates and aggressively pushed short-term interest rates down to zero, Janet Yellen commented on the cries of prominent hedge fund managers that this would immediately lead to disastrous runaway inflation of the type that plagued the US in the late 1970s. Her reply was “We should only hope,” or words to that effect.

She didn’t elaborate …but I will:

1. The threat to the world at that time was just the opposite of inflation. The real threat was deflation, or systematically declining prices. If prices are falling at the rate of, say, 2% a year, making monetary policy accommodative means lowering the Fed Funds rate to -4%. In practical terms, this is impossible. So monetary policy is ineffective and a rerun of the Great Depression ensues. Clueless financiers to the contrary, everything possible had to be done to avoid the deflationary outcome.

2. Inflation , in contrast, is a little like the flu. Treatment is well-understood and straightforward to put into effect. So, yes, it may be unpleasant but we definitely know how to handle the situation.

where are we now?

The biggest problem the Fed has continues to be that it can’t create enough inflation. The price level has remained stubbornly under the Fed’s target of a 2% average annual increase.

In the US at least, inflation is all about wages. Nothing else is big enough to matter. The (lack of) inflation problem is that there’s still enough available labor in the economy that employers don’t have to raise wages, either to find new workers or hold onto existing staff.

On the one hand, the Fed would like to begin to return interest rates to normal: a

–five-year ICU stay can’t be good for a patient;

–with rates at zero the Fed has no ability to respond to any other economic disruption;

–world bond markets appear awfully bubbly at the moment; and

–the Fed is arguably an enabler of a dysfunctional Congress/administration.

On the other, the last thing the Fed wants is to choke off growth and create a recession.

my take

Personally, I’d expected the too-many-employers-chasing-too-few-workers syndrome to have developed long before now, and that we’d have 2%+ inflation already. That’s because I believe that a lot of current unemployment is structural, not cyclical. That is, I’ve been thinking that many long-term unemployed don’t have the educational or technical skills needed in the 21st century workplace. Loose money policy doesn’t do them any good. They need retraining, not low rates.

So far, that’s been wrong.

Taking back of the envelope numbers, there are about three million unemployed workers in the US. The economy is now creating about a million new jobs a year more than the number needed to absorb people leaving school and entering the workforce for the first time. If these are the only factors, and if I continue to be 100% wrong (that is, if there’s no structural unemployment), then we won’t reach full employment until 2017.

This would imply that we won’t have to worry about inflation for a long time. This would also imply that the bond market–and, consequently, the stock market too–could get a lot weirder before the Fed pulls in the reins.